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Category Archives: Tax Policy

Obama’s proposal to raise taxes on those making over $1 million unleashed heated discussion over what the effect of such an increase might be. Will it reduce wealth inequality and close our deficit, or will it hurt the economy by stifling entrepreneurship and job creation? A similar debate took place earlier this year in Britain and resulted in a temporary increase in the tax rate for the top 1% of earners, from 40% to 50%. While it’s too soon for any definitive research on the impact of the change, twenty prominent British economists recently sent a letter to the Financial Times arguing that for its repeal. Does this mean Obama’s approach is misguided as well? Continue reading →

“I reject the idea that asking a hedge fund manager to pay the same as a plumber or a teacher is class warfare. It’s just the right thing to do… This is not class warfare. It’s math. The money’s gonna have to come from someplace.” – President Obama speaking in the Rose Garden today

Today, President Obama unveiled a plan to reduce the deficit by $4 trillion and pay for the new round of economic stimulus, the American Jobs Act, he sent to Congress last week. In a Rose Garden speech about the plan, the President repeatedly emphasized the idea that spending cuts need to be balanced with tax increases. What will likely be one of the most controversialelements of the plan is Obama’sproposal that individuals making over $1 million pay a certain minimum tax rate. Nicknamed the “Buffett Rule” after Warren Buffett’s advocacy of higher taxes for the super-rich, the proposal aims to rectify the fact that, due to the quirks of our tax system,some ultra-wealthy individuals pay lower effective tax rates than upper-middle income households.

Some of you may be scratching your heads, wondering, don’t we already have a tax that’s designed to ensure the wealthiest households pay a certain minimum tax rate? Why, yes we do: the Alternate Minimum Tax or AMT. Individuals with income above a certain threshold have to calculate what they owe under the AMT, which has a different set of rules than the regular income tax system, and then pay whichever is greater, their regular income tax or the AMT. Why do we need a millionaires’ tax if we have the AMT? Simply put, the AMT is not achieving its intended goals. Continue reading →

On Tuesday I wrote about Warren Buffett’s recent op-ed in the NY Times arguing that the super-rich aren’t paying their fair share of taxes. Yesterday Roberton Williams at the Urban-Brookings Tax Policy Center postedan interesting graph that shows how preferential rates for dividends and capital gains income affect the overall tax rates households pay.

Source: Urban-Brookings Tax Policy Center, 2011

The graph is a bit complicated at first glance, so here’s a breakdown:

The blue bars show the average ETR a household pays if they earn less than 10% of their income from dividends and gains on investments.

The red, green, and purple bars show the average ETRs paid by households that earn more of their income from investments. The purple bars, for example, represent households that earn at least 2/3 of their income from these sources.

As I explained the other day and as the graph shows, the more of your income you earn from investments rather than wages, the lower your overall tax rate. And it’s almost exclusively the top earners who are making large shares of their money from investments and getting those lower tax rates shown by the red, green, and purple bars.

If this is still a little confusing, let’s consider two hypothetical families:

Family #1: An upper-middle class family earning $90,000 a year, which puts them in the fourth income quintile. 97% of families in this group make less than 10% of their income from capital gains and dividends. So this family is almost certainly going to be in the blue bar group and will likely pay an average effective tax rate of 16.1%.

Family #2: A super-rich family earning $5 million a year, which places them in the top 0.1% of earners. Almost half of families in this category make more than 10% of their income from capital gains and dividends. If our hypothetical family earns half of their income from these sources, they will be part of the green bar group and will be paying an effective tax rate of around 15%, lower than Family #1.

Guess what share of his income the third richest person in America paid in federal taxes last year? 45%? Maybe 38%? It has to be at least 25%, right? Actually, Warren Buffett paid 17.4%, a lower tax rate than any of the twenty other people working in his office, who paid an average of 36%. Interestingly, Buffett isn’t happy about his low tax bill. Two weeks ago he wrote an attention-grabbing op-ed in the New York Times asking Congress to please tax him and other super-rich folks more.

So, just how does it happen that Warren Buffett pays a lower tax rate than his coworkers? It has a lot to do with how different types of taxes are structured.

The super-rich make most of their income from earnings on investments, rather than wages paid for work (which is where the average, non-retired person makes most of her money). People who “make money with money,” as Buffett puts it, see much of their income taxed at the capital gains rate of 15%, rather than the highest personal income tax rate of 35%.

People who earn more pay a smaller portion of their income in payroll taxes (the taxes designated for Social Security, Medicare, and unemployment), since Social Security taxes are only paid on income up to $107,000.

According to the Urban-Brookings Tax Policy Center, Buffett’s point about the discrepancy between the tax rates on investment income and wage income is a valid and important one. However, most high-earners pay a higher tax rate than Buffett’s 17% and most low- and middle-earners pay a lower rate than the 36% Buffett’s colleagues pay. For Buffett to imply that all, or even most, wealthy people pay a lower tax rate than low- and middle-income people is inaccurate.

The thing is, Buffett’s argument doesn’t really apply to your run-of-the-mill millionaires making $1 or $2 million a year. A lot of those people still earn most of their income from wages so they end up paying highertax rates than someone making, say, $50,000. It’s the super-rich investors like Buffett who get the low tax rates. The average federal tax rate for the top 400 taxpayers is around 18%, which is significantlylowerthan the rate for someone making, for example,$180,000 or $1 million. The graph at left, from the excellent blog Visualizing Economics, shows just how far the average tax rate for the top 400 taxpayers has dropped in the past two decades.

Another thing Buffett hasbeencriticized for is not mentioning the corporate income tax in his article. Corporations pay taxes too, at a rate of about 35%, but since corporations aren’t people the burden of these taxes gets passed on to actual humans – to investors in the form of lower returns on their investments or to workers in the form of lower wages. Buffett’s true net tax rate, some argue, is 17.4% plus whatever share of corporate taxes fall on investors. The problem is, economistscan’t agree on who, investors or workers, bears what share of the corporate tax burden. Given this disagreement, perhaps Buffett was right to leave it out of his argument.

Beneath all this is the question of fairness and how much every group should ideally contribute. For more on this, see one of my older posts here.

Food columnist Mark Bittman had a big, graphics-filled article in this weekend’s NY Times arguing that taxing soda can prevent obesity. He claims that a 20% increase in the price of sugary drinks (soda, fruit drinks, sports drinks) would reduce consumption by 20% and prevent 1.5 million people from becoming obese in the next decade. Money raised through the tax could be used to subsidize the price of healthy food, making it cheaper, and support programs that promote good eating and exercise.

One problem with his argument? When a product becomes more expensive, most people don’t just eliminate it completely from their lives; instead, they substitute something similar but less costly. In other words, if sugary drinks are taxed, consumers aren’t just going to give them up and walk around chugging water all day. Most likely, they will switch to diet drinks (the taxes proposed by Bittman and others apply only to sugary, caloric drinks).

But if we can encourage people to switch from high-calorie to diet drinks that’s a good thing, right? Unfortunately, no. Recent studies have shown that diet soda is linked toobesity and associated health problems like diabetes and high blood pressure. It’s not yet clear whether diet soda itself causes weight gain or whether consuming diet soda is just a sign of an overall poor diet. Either way, taxes that incentivize people to switch from sugary drinks to diet ones, without changing the rest of their diet, won’t do much to curb obesity. Furthermore, research on a proposed soda tax in Illinois showed that many obese people have already substituted diet drinks for sugary ones, so a soda tax wouldn’t affect them much.

I think Bittman has the right idea: we should consider more carefully how prices, availability, and other incentives shape the way people eat, and what role government does or can play in structuring these incentives. Taxing soda might not be a bad step, but I don’t think it will be the cure-all Bittman suggests.

On the upside, the article was accompanied by a cool-looking interactive timeline that shows landmarks in the development of our current high-fat, high-sugar, highly-processed American diet.

If you were to redesign our tax system from scratch, what would it look like? What would each person’s fair share of the burden be?

Our federal system primarily taxes individuals’ incomes, not their overall wealth. You pay taxes on your money when you earn it and you don’t have to keep paying every year on the things you buy with that income, like real estate and financial investments (though you do have to pay taxes on the capital gains you make when you sell these assets). Local tax systems, which are based mainly on taxing property, work differently – you pay taxes on assets you own, every year, as long as you own them.

What’s interesting is that when you look at how the tax burden is spread across different groups, it reflects the distribution of wealth more closely than it does the distribution of income. The top 5% earn 35% of all income but pay a whopping 59% of all taxes. Sounds unfair, right? Until you consider that this group owns 64% of all the wealth in the country.

Where does this pattern come from? The richest Americans’ share of overall wealth is higher than their share of income because they tend to have a greater portion of their wealth in assets (mainly financial investments, real estate, and business ownership), as opposed to middle- and low-income Americans, who have fewer assets and a greater share of their net wealth in the form of cash income. The wealthy’s share of income taxes is greater than their share of income because our tax system is progressive, meaning the affluent pay a bigger chunk of their earnings in taxes than people in the lower income brackets.

There’s been a lot of discussion lately about whether increasing taxes on the wealthy should be part of the solution to our deficit problems. Let’s assume we stick with an income-based tax system; we can still ask ourselves: Should peoples’ taxes correspond to their share of income or their overall wealth? Do the richest Americans pay too much, or not enough?

Like a household whose finances are out of whack, our government can deal with its looming budget deficit in two ways: spend less or earn more. Political leaders are currently negotiating to find the right balance of these two strategies, but severalRepublicans have threatened to block any plan that involves raising taxes. In our current Congress, all but 7 Republican Senators and 6 Republican Representatives have signed Americans for Tax Reform’s well-known pledge to oppose any and all tax increases (only 3 Democratic Congressmen have signed).

But hewing to a mantra of “no new taxes” can be more complicated than it seems, because the division between taxes and spending isn’t always clear-cut. A significant amount of government spending is hidden in the tax code in the form of tax breaks for certain groups: homeowners making mortgage payments, companies conducting scientific R&D, workers receiving employer-sponsored health insurance, and investors earning capital gains. Altogether, the Treasury Department has identified over 170 preferences that cut taxes for specific taxpayers, activities, or types of income. If these “tax expenditures” were structured as spending programs rather than tax breaks, in 2007 they would have accounted for 17% of federal spending.

What makes these tax breaks different from other parts of the tax system, like differential rates based on taxpayers’ incomes? According to a new article by Donald B. Marron, Director of the Urban-Brookings Tax Policy Center, tax expenditures have the same impact on the economy, government budget, and distribution of income as if the government directly handed out checks to the beneficiaries. Elected officials use the tax system because it’s legislatively easier and politically more palatable to insert a benefit into the tax code than to increase discretionary spending by a comparable amount.

“Because tax cuts often sound more appealing to policymakers and voters than spending increases — especially in today’s political climate — the temptation to spend through the tax code is enormous.” – Donald B. Marron, “Spending in Disguise”

Unfortunately, politicians find it much more difficult to eliminate a tax break than to cut a comparable spending program. We saw this a few weeks ago when anti-tax Republicans struggled with how to vote on a measure to end tax credits for ethanol producers. Some, like Senator Tom Coburn, saw the credit for what it is – a spending program in disguise – while others stayed true to their promise not to vote for tax increases of any kind and rejected the measure.

Sometimes spending through the tax code makes sense: it may be more efficient, accomplish important policy objectives, or benefit a broad spectrum of taxpayers. In other cases, these approaches can be overly complex and used to hide unpopular programs that benefit a select few. But the biggest problem is when politicians and voters don’t see tax breaks, good or bad, for what they are – a form of spending – and treat them accordingly.

In honor of the tenth anniversary of the passage of the first Bush-era tax cuts next week, the Economic Policy Institute has released a report summarizing their impact. Perhaps I should say, “in dishonor of the anniversary”, as it is pretty clear where the authors stand on the cuts: “[T]he Bush tax cuts have exacerbated the trend of widening income inequality, accompanied the worst economic expansion since World War II, and turned budget surpluses into deficits.”

While much of their report summarizes existing research, it’s interesting to consider in light of current debates about the deficit and our long-term budget crisis. According to EPI, the Bush-era tax cuts added $2.6 trillion to the national debt, almost half of the new debt we accumulated over the past decade, and have already cost $400 billion in increased interest payments. This recent graph from the Center on Budget and Policy Priorities shows that the cuts added more to our debt than the Iraq and Afghanistan wars, the recession, or the economic stimulus measures implemented under Obama.

The authors of the EPI report also remind us that the tax cuts were originally designed as a response to the 2001 recession, but they suggest the cuts were/are a less effective form of economic stimulus than the tax credits that were included in the 2009 recovery package:

“Moody’s Analytics Chief Economist Mark Zandi estimates that making the Bush income tax cuts permanent would currently generate only 35 cents in economic activity for every dollar in forgone revenue. Targeted refundable tax credits included in the American Recovery and Reinvestment Act, on the other hand, are estimated to generate much more bang-per-buck, ranging from $1.17 for the Making Work Pay Credit to $1.38 for the Child Tax Credit.”

When you think about it in terms of the national debt, which affects everyone, the inequality in the benefit of the tax cuts is quite startling. During the 2010 tax year, 38% of the Bush-era cuts went to those with incomes in the top 1% (over $645,000) and 55% went to those with incomes in the top 10% (over $170,000). Only 1% of the cuts went to families with incomes in the bottom 20%.

I’ll have another post soon on how much letting the cuts expire at the end of 2012 might help our debt crisis.